Re: New Bad Act Disqualification, Disclosures and Certification for Rule 506 Exempt Offerings under Regulation D

by BakerHostetler

Today, new Rules 506(d) and (e) of Regulation D under the Securities Act and changes to Form D (Bad Act Rules) take effect to make all Rule 506 offerings subject to certain "bad act" disqualification, disclosure and certification requirements.[1]

Also, (as summarized in separate alerts[2]), additional new rules and amendments (Solicitation Rules) will take effect[3] to: (i) allow general solicitation in offerings made under new Rule 506(c) and amended Rule 144A; (ii) make clear that private investment funds can engage in general solicitation; and (iii) impose requirements to assure (a) each Rule 144A initial purchaser will be a qualified institutional buyer (QIB),[4] (as is currently required of each Rule 144A resale purchaser) and (b) each Rule 506(c) purchaser will be an accredited investor.[5]

This alert provides an overview of the new Bad Act Rules and certain related matters.

Exempt Offering Market

As part of its rule-making process leading up to adoption of the above rules (New Rules) and its proposal of certain others, the SEC conducted studies of available data about the exempt offering market (including offerings under Section 4(a)2, Rule 144A and Regulation D) and incidences of selected bad acts.[6] General indications from those studies about this market for recent years include:[7]

  • Private funds[8] raised 81 percent of all capital raised in a recent four-year period, through 24 percent of the total offerings (not included are 76 percent of fund filings and 55 percent of operating company filings that listed offering amount as indefinite);
  • The amount of capital raised exceeded that in the registered equity and debt markets;
  • The amount raised by private funds roughly equaled the amount raised by registered funds;
  • The cycles for funds raised in this market correlate highly positively with changes in GDP;
  • Bad actors were detected in three percent of SEC enforcement actions and constituted about 20 percent of bars and final orders of state insurance, securities and banking regulators, federal banking regulators, and the National Credit Union Administration;
  • In 2012, federally registered and exempt reporting investment advisors reported almost $50 trillion in assets under management, and one percent of them reported bad act events; and
  • Approximately 8.7 million natural person accredited investor households existed in the U.S., yet only 234,000 investors (of unspecified varieties) were reported as invested in Form D filings over a four-year period (many are likely repeat investors, so the actual total is probably lower).

The dominance of funds in this market and lack of clarity in reporting received significant SEC focus in the adopting releases for the New Rules and the proposing release for the additional ones referenced below.

Currently, Rule 262 describes certain bad acts by an issuer and certain of its associated persons that prevent it from reliance on Regulation A and Rule 505 and Rule 504 of Regulation D. Rule 506 was not made subject to this limitation when Regulation D was adopted. Many states adopted limited offering exemptions shortly thereafter that applied bad act disqualifications to Rule 506 offerings. Since 1996, states have been prohibited from imposing qualification conditions on Rule 506 offerings beyond requiring Form D or similar information and filing fees.[9]

Events leading up to the Dodd-Frank Act lead Congress to conclude that expanded Bad Act disqualifications should apply to Rule 506 offerings. The Bad Act Rules are broader in several respects than Rule 262 (and require that current tools be re-crafted to make appropriate inquiries). The SEC noted this discrepancy and suggested it might attempt to make bad act disqualifiers uniform as it completes its mandated rule-making to allow Crowdfunding and increase the maximum Regulation A Offering Exemption amount to $50 million.[10]


New Rule 506(d) generally provides that a "Bad Act Event" exists for an issuer when it or any of its "Covered Persons" is the subject of certain current or prior "Triggering Events."

Covered Persons are generally: the issuer; each affiliated issuer and each predecessor to the issuer, each remunerated solicitor; the general partner, managing member or investment advisor (in the case of a pooled investment fund issuer) of the issuer and each such person or entity; each officer participating in the offering, executive officer and director of all of the foregoing; each holder of 20 percent or greater voting equity of the issuer; and each promoter connected in any capacity with the issuer at the time of sale.

Triggering Events are generally certain:

(a) Criminal convictions; injunctions; restraining, final, disciplinary, cease and desist, stop, suspension and false representation orders indicative of fraud, deception, misrepresentation or non-compliance with federal or state laws, regulations or agency rules regulating securities, financial institution, insurance, and commodities futures trading activities; related misrepresentations to the US Postal Service; and

(b) Suspensions and expulsions from membership in, and suspensions and bars from association with, members of certain securities industry self-regulatory organizations, such as FINRA and the NYSE.

Consequences of a current Bad Act Event depend on the date the underlying Triggering Event occurs (e.g., the date the applicable order, judgment, decree, suspension or expulsion was issued versus the date the facts occurred leading up to that event).

A Bad Act Event (whether known or unknown to the issuer) that:

(a) Occurs after September 22, 2013, is a Disqualifying Event and bars the issuer from claiming the safe harbor of Rule 506;

(b) Occurred prior to September 23, 2013, is a Mandatory Disclosure Event under new Rule 506(e), which requires the issuer to disclose written information about the event to each investor a reasonable time prior to purchase of the offered securities in order to claim reliance on the Rule 506 safe harbor.

Relief from these disqualifying or disclosure requirements is possible only if:

(a) After the related sale of securities:

(i) The issuer can establish that it did not know and could not have known, exercising Reasonable Care Under the Circumstances (RCUC), of the existence of the Disqualifying Event (in the case of Rule 506(d)) or Mandatory Disclosure Event information that it failed to disclose (in the case of Rule 506(e)); or

(ii) With respect to Disqualifying Events, the SEC determines it is not necessary under the circumstances that an exemption be denied, after a showing by the issuer of good cause that includes satisfaction of the RCUC requirements of (i) above; or

(b) Before a prospective sale of securities (in the case of certain Disqualifying Events), if the court or authority that entered the related triggering order, judgment or decree advises in writing that disqualification under Rule 506(d) should not occur as a consequence; or

(c) The Bad Act Event:

(i) Related to an affiliated issuer;

(ii) Occurred prior to the affiliation; and

(iii) The affiliated issuer is not:

(A) In control of the issuer; or

(B) Under common control with the issuer by a third party that was in control of the affiliated entity at the time of such event.

Relief before the sale requires actual knowledge of the Bad Act Event and time to negotiate the written advice from the related court or authority or explore opportunities to eliminate the Covered Person status of the bad actor. In this case, the issuer or the Covered Person is attempting to remove an existing disqualification.

Relief after the sale requires establishing that, before the sale occurred, the issuer did not know, and could not have known of the Bad Act Event, exercising RCUC. In this case, the task is to undertake sufficient efforts before the sale:

(a) To discover Bad Act Events (and disclose them timely in the case of Mandatory Disclosure Events);

(b) That will be recognized as the exercise of RCUC in hindsight in light of an undiscovered Bad Act Event that otherwise disqualified or required prior written disclosure.

Initial steps necessary to avoid disqualification include:

(a) Identifying Covered Persons;

(b) Inquiry and diligence about existence of Triggering Events; and

(c) Determining or verifying the date any Triggering Event occurred, all in order to:

(i) Conclude whether a discovered Bad Act Event is a Disqualifying Event or a Mandatory Disclosure Event; or

(ii) Have engaged in efforts sufficient to establish satisfaction of the RCUC standard if a Bad Act Event is not discovered before the sale of securities, but is later found to exist.

Updating is subject to the same standard. A "one shot" offering may not require updating. Continuous offerings most certainly will.

Issuers and seasoned intermediary paid solicitor FINRA members may have in-depth knowledge of executive officers and officers participating in offerings through hiring practices and working relationships. These and regulatory filings required of FINRA members and certain reporting issuers may be enough to "establish" sufficient ongoing knowledge to warrant minimal further inquiry about these officers under some circumstances, according to the SEC.[11] Limiting non-executive officers to those participating in the offering was intended to provide relief for large issuers and intermediaries that have many officers who are not executive officers or controlling persons. Investment managers of private funds were added due to their significance to the current market even though Rule 262 does not apply to investment companies. The term "Investment Manager" is intended to cover advisors, managers and all control persons of private funds.[12]

Prudent issuers of all sizes are likely to want to establish processes and records that return low probabilities of failure by reflecting high levels of inquiry, diligence and judgment.

Some Covered Person categories are objectively defined by title or percent of equity held and these "Known Covered Persons" should be straight-forward for most organizations to identify. The other "functional equivalents" (e.g., promoters in any capacity at the time of sale, whether officers planned to participate in the offering will be those that actually do and the overriding concept that all informal control persons are to be covered) add the challenges of identifying "Unknown Covered Persons" to this process. Prudent organizations are likely to apply robust techniques, such as identifying an initial list of Known Covered Persons and "Possible Covered Persons" and soliciting responses to questions about power, influence and "following the money," in addition to questions that closely track the Covered Persons and Triggering Events category descriptions.

Careful issuers will arrange third-party search services, solicit written responses from Known Covered Persons and Possible Covered Persons and carefully compare the results and reconcile discrepancies. They may require that employees of all Known Covered Persons be solicited to identify all persons known to be the subject of any Triggering Event in order to investigate whether informal power or other reasons cause these identified bad act persons to be Covered Persons.

Of course, person(s) being consciously considered for appointment as Known Covered Persons should be similarly pre-screened. This process should be constructed under appropriate confidentiality, data collection and retention policies and breach response plans.

Changes to Form D will require that each notice claiming reliance on Rule 506 include an issuer certification that the offering is not disqualified for the Bad Act Event reasons stated in Rule 506(d).

A summary styled Bad Act Rules: Operations and Major Definitions, which provides more detail on the Covered Persons and Triggering Events definitions and the Bad Act Rule mechanics, may be viewed in more detail on Bad Act Rules.


The Bad Act Rules basically impact the federal securities law requirements of the exempt offering market as follows:

Current Rule 506 Private Market

This regime is preserved under the Solicitation Rules as current Rule 506 becomes Rule 506(b), retaining current legal requirements, plus the new Bad Act Rules described in this alert.

Section 4(a)(2) Market

This market consists of issuers who tolerate the less certain environment of conducting offerings that do "not involve any public offering" under the core language of Securities Act Section 4(a)(2). The New Rules impact the boundaries of safe harbors rules under this section but do not purport to provide safety in its open sea. Issuers disqualified from relying on Rule 506 due to the Bad Act Rules may take this statutory tack but will not be able to generally solicit (unless they can sell only to QIBs under Rule 144A). Further, overriding "truth in securities" and anti-fraud provisions of federal securities laws would likely require disclosure of bad act events to purchasers.

Rule 144A Market

The Bad Act Rules do not apply to this market, so a Rule 506 disqualified issuer could choose this tack and generally solicit, but sell only to QIBs. General disclosure obligations noted above, the sophistication and experience of QIBs and the historical "exclusive" nature of this market should minimize misinformed sales.

New Rule 506(c) General Solicitation Market

This new market will be required to operate under the requirements of new Rule 506(c). General solicitation will be allowed, but sales will be limited to accredited investors. Issuers will be subject to RCUC standards in choosing verification methods and making determinations that investors are accredited. No particular method will be required, but four non-exclusive methods are deemed reasonable with respect to natural persons. One of these methods is certification of accredited status by a FINRA member. The Bad Act Rules will apply to these issuers and offerings. Rule 506(c) general solicitation offerings will not have an alternative exemption available if disqualifying Bad Act Events exist (other than sales only to QIBs under Rule 144A).

Entrants to this market are likely to include:

(a) Section 3(c)(7) private funds, because they will be able to do so without fear that Rule 506(c) general solicitation will block their exemption from Company Act registration;

(b) Continuous offering private issuers (including Section 3(c)(7) private funds) that can now accept a larger maximum number of equity holders without incurring reporting company obligations under the Securities Exchange Act of 1934 (Exchange Act), since the Jumpstart Our Jobs Act of 2012 (JOBS Act) loosen these constraints;[13]

(c) Operating companies "sponsored" by private equity and venture capital funds;

(d) Continuous offering issuers (such as REITs, MLPs and BDCs)[14] that currently register their distributions under the Securities Act (and in some instances, state blue sky laws), distribute through FINRA members and may view the Rule 506(c) market as a lower cost and faster "regulation light" environment if their models can accept only accredited investors. Many of these issuers are currently surveying repeat investors and intermediaries for accredited investor level indicators and FINRA member certification possibilities;

(e) Seasoned Issuers that currently effect registered offerings to institutional purchasers as a matter of course;

(f) Non-U.S. issuers that are currently large participants in the exempt and registered U.S. markets;

(g) EB-5 Green Card Investor offerings that currently utilize the exempt private market in the U.S. and Regulation S offshore to sell primarily to non-US persons who purchase in increments of $1 million or $500,000; and

(h) Other less experienced issuers and natural person accredited investors, perhaps through social networking and informal structures and relationships.

Some issuers will be better equipped than others to enter this market. It is important that all 506(c) general solicitation issuers have processes in place:

(i) To discover any Bad Act Event before any sales occur (ideally with sufficient lead time to seek appropriate issuing authority relief writings or explore opportunities to restructure relationships so the subject person is not a Covered Person); and

(ii) That withstand RCUC scrutiny if, despite these processes, a Bad Act Event existed, but was not actually known to the issuer until after sales occurred.

Form D and Filing Requirements

A Form D filing with the SEC is due no later than 15 calendar days following the first sale of securities in a Regulation D offering. Since 2008, the SEC has required that Form D filings occur in electronic format via its Electronic Data, Gathering, Analysis and Retrieval (EDGAR) system.[15] In 1989, the SEC removed filing Form D as a condition to reliance on the safe harbor of Regulation D.[16] Currently, Rule 507 provides that failure to file a Form D will disqualify an issuer from relying on Regulation D safe harbor only if it is enjoined by a court for failure to comply with the Rule 503 filing requirements. Even this disqualification does not apply if the SEC determines, on a showing of good cause, that it is not necessary under the circumstances.[17] The New Rules do not change these standards. However, proposed rules described below would deny reliance on Rule 506 to issuers that fail to satisfy increased filing requirements. Issuers that rely on Rule 506 but do not make Form D filings should watch these developments closely.

Proposed Monitoring Rules for Rule 506 Market

The SEC has also proposed to adopt amendments to Rule 156, Rule 506 and Regulation D and changes to Form D.[18] These proposed rules would require, for general solicitation (Rule 506(c)) offerings, advance notice filings, submission of general solicitation materials to the SEC concurrent with first use and certain mandatory disclosures (some of which relate only to private funds). In addition, changes to Form D would require expanded data and closing amendments for all Rule 506 offerings (to address concerns about current requirements and practices in the private market) and enhanced data from Rule 506(c) offerings (to allow the SEC and the public to view development of and compliance practices in this new general solicitation market). In addition, failure to timely file notices for any Rule 506 private or general solicitation offering would deny reliance on that rule for at least a year. Also, amended Rule 156 would make clear that all private fund communications used in or intended to influence the selling process are subject to the anti-fraud provisions of the federal securities laws.

The proposing release for these proposed rules may be viewed at the Monitoring Release and comments about them may be submitted by the public here, through today, September 23, 2013.

If you have any questions about the material presented in this alert, please contact any member of BakerHostetler's Securities Offerings and Reporting, Corporate GovernanceSecurities Litigation and Regulatory Enforcement and Hedge Fund Industry Teams.

[1] Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings, SEC Release No. 33-9414 (July10, 2013) (Bad Act Release). View the Bad Act Release.
[2] SEC Lifts Ban on General Solicitation in Private Offerings and Amended Rule 506 -- Lifting the Ban on General Solicitation.
[3] Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9415 (July 10, 2013); (Solicitation Release).
[4] A qualified institutional buyer is one of several categories of entities that generally own and invest in not less than $100 million ($10 million for registered dealers) in securities of non-affiliated issuers, on a discretionary basis for their own accounts or on behalf of other QIBs. Rule 144A(7)(a)(1).
[5] Rule 501 generally defines an accredited investor who is a natural person as an individual who: (i) has an annual income for the past two years exceeding $200,000, or $300,000 with his or her spouse, each year, with a reasonable expectation of earning that amount in the current year; or (ii) has a net worth or joint net worth with his or her spouse exceeding $1,000,000, excluding the value of his or her primary residence and certain related debt. Under that rule and Section 215(i) of the Securities Act, an entity can also be an accredited investor if: (i) it has at least $5,000,000 in total assets and is a bank, savings and loan, broker-dealer, insurance company, registered investment company, business development company, licensed small business investment company or a certain type of employee benefit plans; or (ii) each of its owners is an accredited investor.
[6] See generally "Economic Baseline," Bad Act Release commencing at page 90.
[7] Bad Act Release at pages 91, 93, 101, 103,109, 112 and 130 and Ivanov/Bauguess Study initially cited at note 252 therein.
[8] Private funds include private equity, hedge and venture capital investment funds that raise capital under Rule 506 (or Securities Act Section 4(a)(2) without safe harbor) and make investments (including non-controlling securities of other issuers) that would require these funds to register as investment companies under the Investment Company Act of 1940 (Company Act), but for exemptions under Sections 3(c)(1) or 3(c)(7) thereof. Generally, a Section 3(c)(1) fund must limit its aggregate investors to 100. A Section 3(c)(7) fund may have unlimited investors, but each must be a qualified purchaser. Generally, a qualified purchaser is (i) any person who owns and invests not less than $25 million in investments on a discretionary basis for its own account or on behalf of other Qualified Purchasers, (ii) any natural person or entity (owned by related natural persons) that owns not less than $5 million in investments, and (iii) certain trusts whose trustee and contributors are all qualified purchasers. Company Act Section 2(a)(51)(A). Currently, if a private fund makes a "public offering" of its securities, neither of these exemptions is available and the fund is required to register under the Company Act.
[9] Securities Act Sections 18(b)(4)(E) and 18(c)(2).
[10] Bad Act Release at page 12.
[11] Bad Act Release at pages 66 and 67.
[12] Note 65 of Bad Act Release.
[13] The JOBS Act raised the threshold number of shareholders of record for mandatory registration (as a reporting company) of a class of equity securities under the Exchange Act from 500 to 2,000 (or 500 who are not accredited), plus certain employees.
[14] REITs are real estate investment trusts typically investing in income producing real property. MLPs are master limited partnerships typically investing in the energy sector. BDCs are business development companies that are publicly registered pooled investment funds that typically make non-controlling venture capital or private equity investments in non-affiliated issuers.
[15] SEC Release 33-8891 (Feb. 6, 2008).
[16] SEC Release No. 33-6825 (Mar 15, 1989) and Monitoring Release (defined below) at page 16.
[17] Rule 507(b).
[18] Amendments to Regulation D, Form D and Rule 156, SEC Release No. 33-9416 (Monitoring Release).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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